Market Bulls May Benefit FromCentral Banks Moves

Central Banks the Key for Movement from Stock Trading Range!

Major Call Activity on VIX Options!

by Ian Harvey

July 30, 2012

Introduction

The market bulls proved victorious yet again last week, as encouraging developments in Europe overshadowed lackluster earnings from the tech sector. And now, investors' appetite for risk could increase even more this week, should global central-bank moves pan out in the bulls favor.

"Spanish and Italian bond markets rallied yesterday as investors cheered Draghi's signal that the ECB is prepared to intervene to reduce soaring yields. Now he has to deliver, or face deep disappointment on financial markets, analysts said. The risk in doing so is alienating key policy makers on the ECB council, such as Bundesbank President Jens Weidmann. The Bundesbank reiterated its opposition to bond purchases today."
- Bloomberg, July 27, 2012

“…..Going back to early June, the SPX has grinded higher in a very choppy fashion. …..staring at resistance from the 2011 calendar-year high just above current levels, while support at 1,333 -- double the March 2009 low and a 38.2% retracement of the June low and July high…..”
- Options Expiration Expectations , July 16, 2012

“….. Since April, there’s been a huge spike in short interest on all optionable stocks. In fact, the number of shares sold short recently climbed above the peak seen last September. What is extremely encouraging here for the market bulls is that short interest just ticked lower, suggesting the shorts could be covering. The last time short interest was this high and rolled over; there was a 30% rally in the SPX over the next six months. Whether this likely to happen again is anyone’s guess, but it's another sign that siding with the market bulls is probably a wise move.....In conclusion, the odds of higher prices are still very good right here."
- Indicators Offer Uplift to the Stock Market, July 23, 2012

Well, finally some news out of Europe that's a little easier to digest. In addition to the Opening Ceremonies and the arrival of the 2012 Summer Olympic Games in London, ECB President Mario Draghi sent a signal that bold action may be taken by the 'European Central Bank - ECB' to stabilize the euro -- a message market participants have long been waiting for in the midst of the continuing European sovereign-debt crisis. So, the battle between market bulls and bears since April -- which has essentially resulted in a stalemate -- may take on a new twist.

The Standard & Poor's 500 Index (SPX - 1,385.97) soared higher on Draghi's remarks, and broke north of the roughly 40-point range -- between the 1,333 area (double the March 2009 low) and the area just above 1,370 (2011's calendar-year high) -- it's been exploring since mid-June. While this is encouraging, there have been a few "fake-out" moves above 1,370 that eventually reverted this month, so a continual watch on this level is necessary. But, as the Bloombergexcerpt above describes, all eyes will be on the ECB meeting this Thursday -- which could be a catalyst that dictates a move out of the short-term range, in one direction or the other, depending on the outcome.

With support on the SPX holding in the 1,333 area last week, another encouraging sign for the market bulls was the CBOE Market Volatility Index (VIX - 16.70) failure to topple the area that is 50% above this year's intraday and closing lows of 13.66 and 14.26, respectively. This resistance area is between 20.44 and 21.39, and, as you can see on the chart below, the VIX failed to overtake this region before falling back below the ’round-number’ 20 strike late in the week.

The VIX and Options Activity

Turning to option activity on the VIX and major exchange-traded funds (ETFs) like the S&P 500 SPDRS (ARCA: SPY - 138.68), PowerShares QQQ ETF (Nasdaq: QQQ - 64.87) and Russell 2000 iShares Index (ARCA: IWM - 79.32), it is obvious that there is major call activity on VIX options, amid little put activity on the SPY, QQQ and IWM. It may be that this light put activity on equity-based ETFs is that hedge funds remain underweight, and the fact that this group is not in accumulation mode could be why the market has struggled in recent months. The good news for the market bulls is that equities have been relatively resilient, despite a lack of a major bid from the hedge-fund players.

Also, as you can see in the chart immediately below, the surge in the VIX's 20-day buy (to open) call/put volume ratio has been coincident with a decline in equities. In prior instances when this ratio trended higher, equities coincidentally rose, and the interpretation was that hedge funds were using VIX calls to hedge equity long positions they were accumulating. This pattern has changed, and the view of the rise in the VIX call/put volume ratio is a sign of speculative bets against the market. In other words, speculators are purchasing VIX calls in anticipation of profiting from a sell-off in equities that drives VIX futures higher. This interpretation is certainly consistent with the build-up in short interest in recent months, as noted in the article ’Indicators Offer Uplift to the Stock Market’. An interesting observation is that any unwinding of these bearish speculative bets could be supportive of equities. Furthermore, a rollover in this ratio could have bullish implications, as it could signal more short-covering.

Conclusion - Market Bulls to Endure!

In conclusion, hopefully market bulls will still endure, as expectations are low, which sets up a favorable risk/reward environment for the bulls. Short-term traders should be aware that the stock market is at the top of the recent range, and should have exposure to both a breakout and a failure at resistance. The sentiment backdrop suggests a breakout above the range could drive a sustainable rally, with the outcome of the ECB meeting in the week ahead a potential catalyst.